THE BIG PICTURE: How fear drives markets

If you wanted to get a good textbook example of a ‘fear-driven’ event, it is the so-called Japanese nuclear crisis. It started with one of the biggest earthquakes in the modern era. But clearly that earthquake wouldn’t have had a major impact on global financial markets if it weren’t accompanied by a destructive tsunami and then by the damage to nuclear facilities in north-eastern Japan.

The panic that followed news of radiation leakage at the nuclear plants was understandable. Most investors haven’t had any experience with such events, and the initial response was to dump shares and commodities and to factor in significant monetary stimulus.

It is hard to work out how Australia would be affected by a nuclear crisis in Japan, but still investors dumped stocks, driving the local sharemarket down by over 2%. The Aussie dollar fell more than US3 cents and the chances of an imminent rate cut soared to more than 60%. Clearly there was a lot of uncertainty about the ramifications of a nuclear plant meltdown. But that was also fed by misinformation about nuclear power and the industry more broadly.

While questions are being raised about the future of nuclear power, it is worth highlighting that many countries across the globe already have high reliance on nuclear power without key problems and other countries are pushing ahead with plans for nuclear power plants. In France, nuclear plants provide 80% of power and there have been no major incidents. In China there are 13 nuclear power plants with 25 currently under construction. In addition there are a further 52 plants planned and another 72 plants proposed.

But what about the Japanese situation? Well, as always it is best to defer to the experts – impartial experts, that is, those that neither promote, nor are fierce critics of, the nuclear industry. One such person is Dr Josef Oehman from MIT. He states that “there was and will not be any significant release of radioactivity.” Perhaps. It depends how you define “significant”.

But Dr Oehman has gone into significant detail in explaining how the Fukushima plants work, the type of fuel they use and containment devices that are in place. Eventually, considered explanations like this will filter out through the media and into the wider community. But the risk in the short-term is that misinformation will continue.

Hopefully the event will have a positive side in that there will be greater understanding of the nuclear power industry, how each of the plants work, as well as more focus on the safety mechanisms in place. For Japan, the other implication of the damage to the nuclear power plants is ongoing power needs. In the short- to medium-term, Japan will have to rationalise power and that will hamper economic recovery.

The week ahead

Last week we spoke about a thinning out of the economic calendar. Well the coming week calendar looks like a virtual wasteland in terms of fresh economic or financial events to provide direction for investors. Certainly that is the case in Australia, although there is still a good spattering of economic data in the US.

In Australia, the week kicks off with February data on imports to be released on Monday. This is one of the more timely economic indicators and highlights spending made by consumers and businesses. But there are also complications such as the influence of the Australian dollar, lumpy imports like airplanes and rising fuel imports caused by higher oil prices. But the data is certainly worth dissecting.

Also released on Monday is data on enterprise bargaining claims, but the figures are dated, covering the September quarter last year.

Then there is a gap until Thursday when the Reserve Bank releases its bi-annual Financial Stability Review and assistant governor Malcolm Edey delivers a speech. The financial sector will be given a clean bill of health while Edey has the opportunity to outline Reserve Bank views on the Japanese situation.

And on Friday the Bureau of Statistics releases its financial accounts for the December quarter. These figures are a treasure trove of information including data on overseas holdings of shares, financial wealth levels of households and cash holdings by businesses and superannuation funds.

In the US, the housing market is centre-stage over the coming week. On Monday, February data on existing home sales is released with home price figures on Tuesday and new home sales on Wednesday.

Existing home sales are expected to have softened from a 5.36 million annual rate in January to 5.20 million in February. Despite soft home prices, the market won’t fundamentally recover until there are less people on dole queues. But new home sales are expected to have edged higher from a 284,000 annual rate in January to 290,000 in February. Harsh winter weather has been affecting the monthly readings in this series.

Also on the agenda this week is the Chicago Fed index on Monday, Richmond Fed manufacturing survey on Tuesday, durable goods orders on Thursday and economic growth (GDP), consumer sentiment and corporate profits on Friday.

Economists expect that the final estimate of economic growth in the December quarter (they have three attempts at estimating growth) will be confirmed around 2.9/3.0%. In Australia, economic growth stands at 2.7% so you can understand the willingness of foreign investors to put their money to work in the US at present.

Sharemarket

In light of the fear-driven sell-off on global sharemarkets in response to the crisis in Japan, it is always useful to come back to fundamentals. We have assessed 12-month forward price-earnings ratios for a raft of markets across the globe provided by FactSet.

Of the 70 regions assessed, only 14 have PE ratios that are higher than their five-year averages. For the “world” market, the current PE ratio of 13.61 is almost 10% lower than the decade average and stands at a seven-month low. Interestingly the most under-valued region is Austria with the PE ratio 64% below the 5-year average. More understandable is the next cheapest – Japan – with the forward PE ratio (15.28) more than 53% below the five-year average.

The forward PE ratio for the Australian market stands at a seven-month low of 12.7, which is 14.2% below the five-year average. Now clearly with investors far more conservative across the globe, the current lower PE ratios may prove the “new normal.” Unfortunately we won’t know the answer on this one for some time.

Interest rates, currencies & commodities

It seemed that the Aussie dollar would remain permanently parked at US101 cents, but along came the Japanese nuclear crisis to shake things up. In the past, the Aussie dollar has been the first casualty of global crises, but this time around the reaction has been reasonably muted. The Aussie did fall away to below US98 cents, but then bounced. Most investors still vividly remember the Aussie at US47.75 cents in April 2001. CommSec continues to believe that the Aussie will hold US99-102 cents through to midyear before easing to US92 cents later in 2011 as attention shifts to tighter monetary policy in the US.

With the Japanese nuclear crisis taking centre-stage, the other “crisis” – in the Middle East – moved to the back burner. This crisis again is one driven more by fear and speculation, rather than fundamentals. Once stability returns to the region and there are reduced fears of oil supply disruptions then the price of crude will probably return to US$85-90 a barrel. The world is well supplied with oil as highlighted by US gasoline inventories at 21-year highs.

The Japanese situation is adding a complication to the interest rate outlook. At one point last Tuesday the chances of an April rate cut had soared to over 60%. Financial markets still believe that rate cuts are more likely in coming months, rather than rate hikes. But the situation is fluid. CommSec believes a longer period of interest rate stability is more likely.

Craig James is chief economist at CommSec.